Foreign Partnerships in Estate Tax Planning for NRAs

In 2000, total U.S. gross estates of nonresident aliens (NRAs) reported on U.S. estate tax returns exceeded $132 million; see Jacobson, “Federal Estate Tax Returns Filed for Nonresident Aliens, 1999 and 2000,” Statistics of Income Bulletin (Summer 2002), available at www.irs.gov/pub/irs-soi/00nraest.pdf. For assets directly owned by NRAs, estate taxes of up to 55% may apply at the time such property is transferred at the NRA’s death. Much of this tax can be eliminated with proper planning, but at potentially significant income tax costs.

Using foreign partnerships to hold U.S. assets of NRAs can bring significant estate and income tax benefits over the more traditional foreign corporation. However, their significant uncertainty for estate tax purposes has generally discouraged such use for estate tax planning. In some cases when it may be possible to reduce or mitigate these risks, the potential benefits of foreign partnerships could turn them into a more widely used estate tax planning vehicle.

NRA Estate Taxation—General Rules

The method of computing estate taxes on an NRA’s gross estate is basically the same as that for a U.S. citizen or resident, except that the NRA’s estate is taxed only to the extent of its U.S.-situs property, and it receives a much smaller unified credit. Generally, under Regs. Sec. 20.2104-1(a), the situs of estate property depends on where it was located when the NRA died. One important exception under Regs. Sec. 20.2104-1(a)(5), is the situs of domestic corporate stock, which is determined by the place of incorporation. Thus, according to Regs. Sec. 20.2105-1(f), stock in a U.S. corporation owned by an NRA is deemed situated in the U.S. and subject to estate tax, even if the shares and/or corporate assets are physically present outside the U.S. Likewise, stock in a non-U.S. corporation is deemed to be situated outside the U.S., even when the stock or assets are physically in the U.S.

While the above situs rules are clear, no clear rules for determining situs of partnership interests exist in the Code, regulations or any other authority. Further, the IRS generally will not issue determinations on the imposition of estate tax while a taxpayer is alive. Such unpredictability has discouraged the use of partnerships for estate planning by foreign estates. Although the Code does not provide a situs for foreign partnerships, it does provide for income sourcing; see Regs. Secs. 1.861-1(a) and 1.864-4(a). U.S.-sourced effectively connected income earned by a foreign partnership and passed through to its partners, results in a U.S. filing obligation to the foreign partnership and its partners, under Regs. Secs. 1.6031(a)-1(b) and 1.6012-1(b).

Foreign Corporations

The more certain and commonly used way for NRAs to hold U.S. property has been through a foreign corporation. The certainty stems from the regulations, which clearly define stock in foreign corporations as non-U.S.-situs property. To achieve such structure, the NRA acquires the foreign company’s stock; the foreign company, in turn, acquires and holds U.S. real property, stocks and any other U.S.-situs property. At the time of the NRA’s death, his or her estate would be comprised solely of the foreign corporation stock. That stock is then transferred to beneficiaries without any U.S. estate taxation. Had the NRA acquired the U.S. property directly, it would have been subject to U.S. estate taxes at the time of death.

As noted previously, one of the main disadvantages of using foreign corporations to hold U.S. property is the higher tax rates imposed on its eventual disposition. The gain on the sale of the U.S. property will be taxed at the corporate rate (34%), rather than the 15% long-term capital gain rate for individuals.

Foreign Partnerships

Using foreign partnerships for estate tax planning can substantially benefit an NRA’s estate. Important advantages are the basis step-up of assets held at death under Sec. 754 and the benefit of the lower long-term capital gain rates on a disposition of the assets. In addition, if the heir is a U.S. citizen or domiciliary, the foreign partnership would help avoid potential double taxation and also insulate heirs from strict rules that apply to certain foreign corporations (e.g., controlled foreign corporations (CFCs), foreign personal holding companies (FPHCs) and passive foreign investment companies (PFICs)).

In addition to the normal Sec. 1014 basis step-up to fair market value (FMV) at death, a partnership can also step up the basis of the underlying assets to FMV under Sec. 754. As a result of the latter, taxable gain to the U.S. heir will be lower on an eventual sale of the appreciated assets, disposition of the partnership interest or bequest to the next generation. Moreover, stepping up the inside basis of the partnership assets may yield additional depreciation deductions for the U.S. heir.

Example: A, B and C were equal partners in foreign partnership ABC. Each partner originally contributed $10,000; ABC used these contributions to purchase a U.S. depreciable asset. At A’s death, the fully depreciated asset has a $45,000 FMV. With a Sec. 754 election, A’s U.S. heir, D, will receive a partnership interest of $15,000; D’s inside basis in such asset will also be $15,000. D takes an additional $12,000 of depreciation over the next two years. At that point, ABC sells the U.S. asset for $60,000. D recognizes $17,000 taxable gain, while B and C recognize $20,000 gain each. Total taxable gain on the sale of the asset is $57,000.

In the example, when ABC sells the U.S. property, the income or gain from the sale is deemed U.S. effectively connected income, requiring the partnership to withhold taxes (unless exempted by treaty); see Regs. Secs. 1.897-1(a), 1.1441-5(c) and 1.1445-1(a). However, had ABC been organized as a foreign corporation, it would have recognized $60,000 taxable gain on the sale, as there would have been no Sec. 754 basis step-up on A’s death. Besides the additional $3,000 in taxable gain, D would have also been subject to dividend taxes on the distribution of the sale gain.

The ability to avoid the rules on CFCs, FPHCs and PFICs is a great reason to use a foreign partnership to hold U.S. property. On stock transfers to a U.S. heir, a foreign corporation may be classified as a CFC (generally, under Sec. 957(a), more-than-50% owned by U.S. shareholders), a FPHC (generally, under Sec. 552(a), at least 60% of gross income is FPHC income as defined in Sec. 954(c), and the entity is more-than-50% owned by five or fewer U.S. citizens or residents) or a PFIC (generally, under Sec. 1297(a), at least 75% of gross income is FPHC income or 50% or more of its assets produce passive income). When a corporation is classified as any of these entities, a U.S. beneficiary inheriting an interest will be taxed currently on his or her pro-rata share of the subpart F income, under Sec. 951(a). The burdensome reporting requirements and complicated calculation of subpart F income, in addition to possible taxes, present a considerable drawback to the U.S. heir.

Reducing the Estate Tax Risks of Using Partnerships

The lack of certainty of the situs of the partnership interest for estate tax purposes and the IRS’s reluctance to provide guidance are the most explicit risks of using foreign partnerships for estate tax planning. No authority supports the position that a partnership interest, like stock, is an intangible asset with situs determined by place of organization. However, certain characteristics may increase the likelihood that a foreign partnership interest will be treated as an intangible asset.

First, the partnership must qualify as a separate legal entity under the laws of the country in which it is created, and the entity must survive the death of a partner. These attributes are essential for the partnership to be treated by the IRS as an entity separate from its owners and not simply as an aggregate of underlying assets owned by the partners. If the partnership is to be treated as a collection of assets owned directly by the partners, U.S.-situs assets would be subject to estate tax on their transfer to beneficiaries.

Second, the majority of the general business of the partnership and a substantial portion of the total value of its assets must be deemed carried on/located outside the U.S. An interest in a partnership organized in a foreign country that conducts most of its business and has a substantial portion of the total value of its assets in the U.S. will be deemed to have nexus with the U.S. The partnership interest would be U.S.-sourced and taxable in the U.S. on death. In Rev. Rul. 91-32, for example, the IRS deemed the gain or loss on an NRA’s disposal of a foreign partnership interest to be U.S.-source and taxable as if the partnership were engaged in a trade or business in the U.S.

Finally, although there is no specific authority, another potentially favorable circumstance could exist when the foreign entity is, by default, treated as a partnership for U.S. income tax purposes, but regarded as a corporation in the country of organization (e.g., a Nova Scotia Unlimited Liability Company (NSULC)). Regs. Sec. 301.7701-2(b)(8)(ii) clearly states that an NSULC will not be treated as a corporation for U.S. income tax purposes, but in Canada, such entities are taxed as corporations. Note: A check-the-box election to treat a foreign corporation as a partnership would not likely work; most authorities believe that such an election is effective for both income and estate tax purposes. Thus, it does not seem possible to check the box to create an entity that is a partnership for income tax purposes, but a corporation for estate tax purposes.

Conclusion

NRAs’ use of foreign partnerships to hold U.S. property may be a viable estate planning tool, especially when their beneficiaries are U.S. citizens or domiciliaries. The decision to use foreign partnerships should be carefully made only after considering the risks posed by U.S. estate and international tax laws. However, it is possible to reduce the risks of having the interest in the foreign partnership treated as U.S. property, by ensuring the entity meets certain characteristics. In such cases, the benefits of the basis step-up under Sec. 754, the lower capital gain rates on an eventual disposition of the U.S. assets, the avoidance of the CFC, FPHC and PFIC rules and the elimination of one level of taxation to the U.S. beneficiaries, can be tremendous.

From Rafael Carsalade, Pannell Kerr Forster of Texas, P.C., Houston, TX